Save Article

EMI Dodges Key Issues
About Monetary Policy

Updated Jan. 13, 1997 12:01 a.m. ET

FRANKFURT -- The European Monetary Institute faced its first major quandary head-on -- and ducked.

The forerunner of the European Central Bank had been expected to recommend on Friday which economic indicator makes the better target for the future bank's monetary policy: money-supply growth or inflation. Instead, the EMI dodged the issue, saying that the future central bank would have to make that call.

The long-awaited recommendation was seen as an early indication of how the European Central Bank will handle monetary policy. Investors are looking for clues about whether the future common currency, the euro, will replicate the mark's role as a strong currency aloof of politics -- or whether, like some other European currencies, it will be available as a weapon for trade wars. At its simplest, the two approaches are represented by the Bundesbank and the Bank of England.

The Bundesbank has always put money-supply targets at the core of its policy, ignoring cries from businesses that an appreciating currency crimps their competitiveness. The Bank of England, by contrast, tailors official interest rates to price trends and doesn't hesitate to boost U.K. exports by letting the pound be devalued.

The EMI has now papered over the differences between those approaches, saying there's little difference these days between the two. The recommendation came in a 100-page report in which the EMI set forth its proposals for mechanisms that could ensure that the European Union has a strong, credible monetary policy after the launch of a single currency on Jan. 1, 1999. Alexandre Lamfalussy, the Belgian who heads the EMI, told reporters that that data on both money supply and inflation are essential to running monetary policy these days.

He has a point: Even Bundesbank and Bank of England officials concede that their interest-rate decisions are driven by more than just one set of data. The Bank of England, for example, officially targets inflation, but frets if one of its measures of money expands too rapidly. The Bundesbank, for its part, considers inflation, exchange rates and the state of the economy as well as its much-hyped M3 money-supply figures. "The differences between these two approaches is diminishing quite fast," Mr. Lamfalussy says.

Even so, the EMI report makes an early nod to the method favored by the British, warning that demand for money may not be that stable in the early stages of EMU. Tracking it alone could be prove misleading and potentially damaging the credibility of the new central bank, the report says. So the report leaves the final decision to the European Central Bank, which will also will take over in 1999.

The EMI did rule out three other possible monetary targets: interest rates, nominal income and exchange rates, a policy now followed in the Netherlands, Belgium and Austria.

If all this seems a bit arcane, it is. "It's a theoretical red herring," says Guenther Thumann, a former German government official who now is Salomon Brothers' EMU expert.

Yet behind the academic debate lies the serious question of how the European Central Bank will convince financial markets that it's serious about ensuring the vaunted goal of price stability and is going about it in the right way. At the same time, it must forge a consensus among central bankers, some of whom chafe at following the Bundesbank's lead.

Already, some investors fear that the euro will be weak compared with the mark and that the new monetary zone will include countries that qualified for EMU only by dint of bookkeeping tricks and unsustainable belt-tightening. If that view spreads, it could mean higher interest rates for Germans and citizens in other so-called "core countries," some of whom already are resisting giving up their national currencies.

The first round of EMU participants will be named in early 1998 on the basis of economic criteria such inflation rates and public-sector deficit levels.

Mr. Thumann, for one, is betting that in practice, the European Central Bank will act a lot like the Bundesbank. After all, analysts say, German central bank often gives little more than lip service to its more than 20-year-old tradition of targeting the growth in M3, or cash in circulation, sight deposits, time deposits and most savings accounts. Even so, the Bundesbank and the mark have become the anchor of Europe.

"If the European Central Bank is a clone of the Bundesbank, it increases the chances that the currency will behave like the Deutsche mark," says Michael Lewis, senior economist with Deutsche Morgan Grenfell in London. Mr. Lamfalussy himself insists that the euro "is likely to be a stable and reasonably strong currency."

But the unresolved questions extend beyond inflation and money-supply targets. Again, the lines are drawn between Germany and the U.K. One is whether to use bank reserve requirements in executing monetary policy. The Bundesbank insists that reserves are a crucial tool for controlling short-term interest rates, even though it is now reducing the percentage of money banks are required to set aside in non-interest-bearing accounts. German banks now must keep a collective total of about 40 billion marks at the Bundesbank daily.

Not so, says the Bank of England, which argues that market forces do a better job of keeping short-term interest rates under control.

As with inflation and money supply, the EMI report leaves the final decision on reserve requirements to the European Central Bank. The EMI, Mr. Lamfalussy notes in a careful bit of fence-walking, is only required by the Maastricht Treaty to set up the tools in case central bankers want to use them. But the burdens placed on banks through reserve requirements -- read competitive disadvantages -- have diminished in recent years, he says.

Despite all the unanswered questions, the report appeared to satisfy many government officials. "Even if all the details of monetary policy aren't yet laid out, the concept presented by the EMI offers an early orientation framework for financial markets domestically and abroad," German Finance Minister Theo Waigel said.

Besides, says Mr. Lewis of Deutsche Morgan Grenfell, "they can't really make a decision on the juicy stuff until 1998."